In most financing transactions, particularly project finance transactions, lenders seek to obtain security over all of a borrower’s assets. One crucial asset that sometimes does not get sufficient attention is insurance proceeds. Lenders are accustomed to ensuring access to the borrower’s insurance coverage through “additional insured” or “loss payee” provisions. In theory, if there is an “occurrence” or event resulting in physical loss or damage to the borrower’s property or even ensuing business interruption losses, the lender, as “additional insured” or “loss payee,” is independently entitled to recover the value of the damaged property or lost profits directly from the insurer as a party to the applicable policy—even if the insured is in bankruptcy. In practice, this strategy usually works well. After all, the overriding legal rule dictates that policies and their proceeds are only the property of the bankruptcy estate if the borrower is the beneficiary of such proceeds under the relevant policy. Proceeds payable to an “additional insured” lender or “loss payee” are not property of the estate, particularly when the loss occurs pre-petition.
Yet, in some recent cases, lenders have been denied post-bankruptcy recovery of the proceeds of a debtor’s policy, even if the lender is a named insured, additional insured or other designee. Many, but not all, of these cases have been decided in the context of post-petition casualty losses. Given the uncertainty created by these outcomes, it is important to recognize what lenders can do to preserve access to insurance proceeds when collateral is lost or damaged.
As a preliminary matter, to the extent many decisions focus on the dual status of creditor and lender as claimants under the policy in finding proceeds to be property of the estate, where possible, lenders should not only be granted “additional insured” status but also be made the sole “loss payee.” Lenders may also negotiate specific contractual terms (beyond the requisite designation of “additional insured” or “loss payee” status) giving them priority to insurance proceeds in bankruptcy. Alternatively, some courts have recognized that a perfected security interest in collateral will automatically become a perfected security interest in the proceeds of insurance for the loss of such collateral. Nonetheless, even a perfected security interest in the collateral and loss payee status for some lenders has been found to be insufficient to avoid an award of casualty insurance proceeds to the debtor estate.
Lenders cannot be assured of complete protection unless the inconsistencies in current legal authorities are resolved and a coherent consensus rule among courts emerges. Until then, access to insurance proceeds in bankruptcy may be maximized by (1) obtaining and confirming sole “loss payee” status for the lender under the debtor’s property and casualty policies; (2) contracting with the debtor for express waivers of insurance proceeds covering loss or damage to insured collateral (or business interruption, if appropriate); and (3) perfecting security interests in insured collateral as well as payments from an insurer for loss or damage to secured collateral.